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  <h1>Explanations of the yield curve</h1>

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Three theories explaining the upward slope of yield curve are:
<ul>
  <li> Expectation theory
  </li>
  <li> Market segmentation theory
  </li>
  <li> Liquidity preference theory
  </li>
</ul>
How to describe the movements of the yield curve:
<br>
Examples: The yield curve would fall at the long end. (short end) Push up the long end
Such funds will not be tied to the long end and will move to the short end where expected returns will be higher.


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    Expectation theory
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      The expectations theory suggests that the market expects future short-term interest rates to rise, thereby meaning that long-term interest rates (which can be replicated by a series of short term investments) are higher than current short-term interest rates and, hence, the yield curve slopes upwards.
      <br>
      Problems with this theory:
      <ul>
        <li>
          Lack of securities: In the existing markets an investor is not guaranteed to always find the necessary securities. For example, the supply of gilts is determined by the way the DMO chooses to finance the government’s borrowing requirements. In this case yields would reflect supply and demand in each term to redemption segment (see below).
        </li>
        <li>
          Matching of assets to liabilities: for an investor with a known fixed liability the perfect hedge would be a security of similar term and payment. Thus the investor would not be indifferent.
        </li>
      </ul>
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    Market segmentation theory
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      Market segmentation theory suggests that demand at different terms comes largely from investors with liabilities of that term.
      <br>
      <br>
      Thus, demand for short-dated bonds is largely driven by banks and non-life insurance companies
      (who typically have short-term liabilities), whereas demand for long-dated bonds is largely driven by
      life insurance companies and pension funds (who typically have long-term liabilities).
      <br>
      As a result, there is often a natural lack of demand for medium-dated bonds
      <br>
      Problems with this theory:
       <ul>
        <li>
          This theory holds in the sense that investors with short-term liabilities will hedge with short-term securities. Similarly for medium- and long-term liabilities.
        </li>
        <li>
          Also investors may be drawn away from their “preferred habitats” if expectations differ from actual yields so that yields become determined by a combination of expectations theory and market segmentation.
        </li>
      </ul>


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    Liquidity preference theory
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      The liquidity preference theory contends that, as short-term bonds have a more stable market value than long-term bonds, the yield on long-term bonds should be (slightly) higher to compensate for the extra volatility
      <br>
      Problems with this theory:
     <ul>
        <li>
          Matching of assets to liabilities: investors with long-term liabilities will prefer to hedge their liabilities with similar term liabilities. For such investors, liquidity might not be their first consideration
        </li>
      </ul>
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  <p> Author: Mengke, Lyu</p>

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